UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

 

Commission File Number 0-7087

 

 

Astronics Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

130 Commerce Way, East Aurora, N.Y. 14052

(Address of principal executive office)

 

Registrant’s telephone number, including area code

(716) 805-1599

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12 (g) of the Act:

$.01 par value Common Stock; $.01 par value Class B Stock

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o     No þ

 

As of March 6, 2007, 8,062,325 shares were outstanding, consisting of 6,686,077 shares of Common Stock $.01 Par Value and 1,376,248 shares of Class B Stock $.01 Par Value. The aggregate market value, as of the last business day of the Company’s most recently completed second fiscal quarter, of the shares of Common Stock and Class B Stock of Astronics Corporation held by non-affiliates was approximately $90,758,774 (assuming conversion of all of the outstanding Class B Stock into Common Stock and assuming the affiliates of the Registrant to be its directors, executive officers and persons known to the Registrant to beneficially own more than 10% of the outstanding capital stock of the Corporation).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders to be held May 9, 2007 are incorporated by reference into Part III of this Report.

 

 

FORWARD LOOKING STATEMENTS

 

This Annual Report contains certain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involves uncertainties and risks. These statements are identified by the use of the “may,” “will,” “should,” “believes,” “expects,” “expected,” “intends,” “plans,” “projects,” “estimates,” “predicts,” “potential,” “outlook,” “forecast,” “anticipates,” “presume” and “assume,” and words of similar import. Readers are cautioned not to place undue reliance on these forward looking statements as various uncertainties and risks could cause actual results to differ materially from those anticipated in these statements. These uncertainties and risks include the success of the Company with effectively executing its plans; the timeliness of product deliveries by vendors and other vendor performance issues; changes in demand for our products from the U.S. government and other customers; the acceptance by the market of new products developed; our success in cross-selling products to different customers and markets; changes in government contracts; the state of the commercial and business jet aerospace market; the Company’s success at increasing the content on current and new aircraft platforms; the level of aircraft build rates; as well as other general economic conditions and other factors. Certain of these factors, risks and uncertainties are discussed in the sections of this report entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

PART I

 

 

Astronics is a leading supplier of advanced, high-performance lighting, electronics and power distribution systems for the global aerospace industry. We sell our products to original equipment manufacturers (OEM’s) in the commercial transport, business jet, military markets, OEM suppliers, and aircraft operators around the world. The U.S. Government is also a major customer of ours. The Company provides its products through its wholly owned subsidiaries Luminescent Systems, Inc., Luminescent Systems Canada, Inc., collectively referred to as (LSI) and Astronics Advanced Electronic Systems Corp. (AES).

 

Strategy

 

Astronics’ strategy for growth is to continue to develop or acquire the necessary technology to evolve into a leading aircraft lighting, electronics and power generation and distribution systems integrator, increasing the value and content we provide on a growing base of aircraft and missile platforms.

 

Products and Customers

 

Astronics’ products are sold worldwide to manufacturers of business jets, military aircraft, missiles, and commercial transports, as well as airlines and suppliers to the OEM’s. During 2006 the Company’s sales were divided 55% to the commercial transport market, 23% to the military market, 21% to the business jet market, and the balance to other markets. Most of the Company’s sales are a result of contracts or purchase orders received from customers, placed on a day-to-day basis or for single year procurements rather than long-term multi-year contract commitments. On occasion the company does receive contractual commitments or blanket purchase orders from our customers covering multiple year deliveries of hardware to our customers. Sales by Geographic Region, Major Customer and Canadian Operations are provided in Note 8 of Item 8, Financial Statements and Supplementary Data in this report.

 

Practices as to Maintaining Working Capital

 

Liquidity is discussed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in the Liquidity section in this report.

 

Competitive Conditions

 

Astronics experiences considerable competition in the Aerospace market sectors we serve, principally with respect to product performance and price, from various competitors, many of which are substantially larger and have greater resources. Success in the Aerospace markets we serve depends upon product innovation, customer support, responsiveness, and cost management. Astronics continues to invest in developing the technologies and engineering support critical to competing in our Aerospace markets.

 

Government Contracts

 

All U.S. Government contracts, including subcontracts where the U.S. Government is the ultimate customer, may be subject to termination at the election of the government.

 

Raw Materials

 

Materials, supplies and components are purchased from numerous sources. We believe that the loss of any one source, although potentially disruptive in the short-term, would not materially affect our operations in the long-term.

 

Seasonality

 

Our business is typically not seasonal.

 

Backlog

 

At December 31, 2006, the Company’s backlog was $99.5 million. At December 31, 2005, the Company’s backlog was $96.1 million.

 

Patents

 

The Company has a number of patents and has filed applications for others. While the aggregate protection of these patents is of value, the Company’s only material business that is dependent upon the protection afforded by these patents is its cabin power distribution product. The Company’s patents and patent applications relate to electroluminescence, instrument panels, keyboard technology and a broad patent covering the cabin power distribution technology. The Company regards its expertise and techniques as proprietary and relies upon trade secret laws and contractual arrangements to protect its rights. We have trademark protection in major markets.

 

Research, Development and Engineering Activities

 

The Company is engaged in a variety of engineering and design activities as well as basic research and development activities directed to the substantial improvement or new application of the Company’s existing technologies. These costs are expensed when incurred and included in cost of sales. Research and development and engineering costs amounted to approximately $10.9 million in 2006, $8.9 million in 2005 and $5.8 million in 2004.

 

Employees

 

The Company’s continuing operations employed approximately 787 employees as of December 31, 2006. The Company considers its relations with its employees to be good.

 

Available information

 

The Company files its financial information and other materials as electronically required by the SEC with the SEC. These materials can be accessed electronically via the Internet at www.SEC.gov. Such materials and other information about the Company are also available through the Company’s website at www.astronics.com.

 

 

Risks Related to our Industry

 

The markets we serve are cyclical and sensitive to domestic and foreign economic conditions and events, which may cause our operating results to fluctuate. For example, demand by the business jet markets for our products is dependent upon several factors, including capital investment, product innovations, economic growth, and technology upgrades. In addition, the commercial airline industry is highly cyclical and sensitive to fuel price increases, labor disputes and economic conditions. A change in any of these factors could result in a reduction in the amount of air travel. A reduction in air travel would reduce orders for new aircraft and reductions in cabin upgrades by airlines for which we supply products and for the sales of spare parts, thus reducing our sales. A reduction in air travel may also result in our commercial airline customers being unable to pay our invoices on a timely basis or at all.

 

We depend on government contracts and subcontracts with defense prime contractors and sub contractors that may not be fully funded or may be terminated, and the failure to receive funding or the termination of one or more of these contracts could reduce our sales. Sales to the U.S. Government and its prime contractors and subcontractors represent a significant portion of our business. The funding of these programs is generally subject to annual congressional appropriations, and congressional priorities are subject to change. In addition, government expenditures for defense programs may decline or these defense programs may be terminated. A decline in governmental expenditures may result in a reduction in the volume of contracts awarded to us.

 

If our subcontractors or suppliers fail to perform their contractual obligations, our prime contract performance and our ability to obtain future business could be materially and adversely impacted. Many of our contracts involve subcontracts with other companies upon which we rely to perform a portion of the services we must provide to our customers. There is a risk that we may have disputes with our subcontractors, including disputes regarding the quality and timeliness of work performed by the subcontractor or customer concerns about the subcontractor. Failure by our subcontractors to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed-upon services may materially and adversely impact our ability to perform our obligations with our customer. Subcontractor performance deficiencies could result in a customer terminating our contract for default. A default termination could expose us to liability and substantially impair our ability to compete for future contracts and orders. In addition, a delay in our ability to obtain components and equipment parts from our suppliers may affect our ability to meet our customers’ needs and may have an adverse effect upon our profitability.

 

Our results of operations are affected by our fixed-price contracts. The nature of our business activities involves fixed-price contracts. Our contractual arrangements include customers’ requirements for delivery of hardware and funded nonrecurring development work that we anticipate will lead to follow-on production orders. For the year ended December 31, 2006, fixed-price contracts represented 100% of our sales. On fixed-price contracts, we agree to perform the scope of work specified in the contract for a predetermined price. Depending on the fixed price negotiated, these contacts may provide us with an opportunity to achieve higher profits based on the relationship between our costs and the contract’s fixed price. However, we bear the risk that increased or unexpected costs may reduce our profit.

 

Contracting in the defense industry is subject to significant regulation, including rules related to bidding, billing and accounting kickbacks and false claims, and any non-compliance could subject us to fines and penalties or possible debarment. Like all government contractors, we are subject to risks associated with this contracting. These risks include the potential for substantial civil and criminal fines and penalties. These fines and penalties could be imposed for failing to follow procurement integrity and bidding rules, employing improper billing practices or otherwise failing to follow cost accounting standards, receiving or paying kickbacks or filing false claims. We have been, and expect to continue to be, subjected to audits and investigations by government agencies. The failure to comply with the terms of our government contracts could harm our business reputation. It could also result in suspension or debarment from future government contracts.

 

If we are unable to adapt to technological change, demand for our products may be reduced. The technologies related to our products have undergone, and in the future may undergo, significant changes. To succeed in the future, we will need to continue to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. Our competitors may develop technologies and products that are more effective than those we develop or that render our technology and products obsolete or uncompetitive. Furthermore, our products could become unmarketable if new industry standards emerge. We may have to modify our products significantly in the future to remain competitive, and new products we introduce may not be accepted by our customers.

 

Our new product development efforts may not be successful, which would result in a reduction in our sales and earnings. We may experience difficulties that could delay or prevent the successful development of new products or product enhancements, and new products or product enhancements may not be accepted by our customers. In addition, the development expenses we incur may exceed our cost estimates, and new products we develop may not generate sales sufficient to offset our costs. If any of these events occur, our sales and profits could be adversely affected.

 

Risks Related to our Business

 

Our products are sold in highly competitive markets. Some of our competitors are larger; more diversified corporations and have greater financial, marketing, production and research and development resources. As a

result, they may be better able to withstand the effects of periodic economic downturns. Our operations and financial performance will be negatively impacted if our competitors:

 

 

We believe that the principal points of competition in our markets are product quality, price, design and engineering capabilities, product development, conformity to customer specifications, quality of support after the sale, timeliness of delivery and effectiveness of the distribution organization. Maintaining and improving our competitive position will require continued investment in manufacturing, engineering, quality standards, marketing, customer service and support and our distribution networks. If we do not maintain sufficient resources to make these investments, or are not successful in maintaining our competitive position, our operations and financial performance will suffer.

 

A write-off of all or part of our goodwill or other intangible assets could adversely affect our operating results and net worth and cause us to violate covenants in our bank credit facility. Goodwill and other intangible assets are a substantial portion of our other assets. At December 31, 2006, goodwill was $2.7 million and other intangible assets were $2.3 million, 6.1% of our total assets of $82.5 million. We may have to write off all or part of our goodwill or other intangible assets if their value becomes impaired. Although this write-off would be a non-cash charge, it could reduce our earnings and net worth significantly. A write-off of goodwill or other intangible assets could also cause us to violate covenants in our bank credit facility that requires a minimum level of net worth. This could result in our being unable to borrow additional funds under our bank credit facility or being obliged to refinance or renegotiate the terms of our bank indebtedness.

 

Our future success depends to a significant degree upon the continued contributions of our management team and technical personnel. The loss of members of our management team could have a material and adverse effect on our business. In addition, competition for qualified technical personnel in our industries is intense, and we believe that our future growth and success will depend on our ability to attract, train and retain such personnel.

 

Future terror attacks, war, or other civil disturbances could negatively impact our business. Continued terror attacks, war or other disturbances could lead to further economic instability and decreases in demand for our products, which could negatively impact our business, financial condition and results of operations. Terrorist attacks world-wide have caused instability from time to time in global financial markets and the aviation industry. The long-term effects of terrorist attacks on us are unknown. These attacks and the U.S. Government’s continued efforts against terrorist organizations may lead to additional armed hostilities or to further acts of terrorism and civil disturbance in the United States or elsewhere, which may further contribute to economic instability.

 

Our facilities could be damaged by catastrophes which could reduce our production capacity and result in a loss of customers. We conduct our operations in facilities located in the United States and Canada. Any of these facilities could be damaged by fire, floods, earthquakes, power loss, telecommunication and information systems failure or similar events. Although we carry property insurance, including business interruption insurance, our inability to meet customers’ schedules as a result of catastrophe may result in a loss of customers or significant additional costs.

 

Government regulations could limit our ability to sell our products outside the United States. In 2006, 1% of our sales were subject to compliance with the United States Export Administration regulations. Our failure to obtain the requisite licenses, meet registration standards or comply with other government export regulations would hinder our ability to generate revenues from the sale of our products outside the United States. Compliance with the government regulations may also subject us to additional fees and costs. The absence of comparable restrictions on competitors in other countries may adversely affect our competitive position. In order to sell our products in European Union countries, we must satisfy certain technical requirements. If we

are unable to comply with those requirements with respect to a significant quantity of our products, our sales in Europe would be restricted.

 

Some of our contracts contain late delivery penalties. Failure to deliver in a timely manner due to supplier problems, development schedule slides, manufacturing difficulties, or similar schedule related events could have a material adverse effect on our business.

 

The failure of our products may damage our reputation, necessitate a product recall or result in claims against us that exceed our insurance coverage, thereby requiring us to pay significant damages. Defects in the design and manufacture of our products may necessitate a product recall. We include complex system design and components in our products that could contain errors or defects, particularly when we incorporate new technology into our products. If any of our products are defective, we could be required to redesign or recall those products or pay substantial damages or warranty claims. Such an event could result in significant expenses, disrupt sales and affect our reputation and that of our products. We are also exposed to product liability claims. We carry aircraft and non-aircraft product liability insurance consistent with industry norms. However, this insurance coverage may not be sufficient to fully cover the payment of any potential claim. A product recall or a product liability claim not covered by insurance could have a material adverse effect on our business, financial condition and results of operations.

 

The loss of a major customer or a significant reduction in sales to a major customer would reduce our sales and earnings. In 2006 we had a concentration of sales to a major customer representing 21% of our sales. The loss of this customer or a significant reduction in sales to this customer would significantly reduce our sales and earnings.

 

We are a supplier on various new aircraft programs just entering or expected to begin production in the near future. As with any new program there is risk as to whether the aircraft or program will be successful and accepted by the market. As is customary for our business we purchase inventory and invest in specific capital equipment to support our production requirements generally based on delivery schedules provided by our customer. If a program or aircraft is not successful we may have to write off all or a part of the inventory, accounts receivable and capital equipment related to the program.

 

 

Not applicable

 

 

The Company owns manufacturing and office facilities of approximately 70,000 square feet in the Buffalo, New York area and is currently constructing an additional 57,000 square feet of manufacturing capacity that is expected to be completed and operational in the second quarter of 2007. The Company owns manufacturing and office facilities of approximately 80,000 square feet in Lebanon, New Hampshire. Astronics AES leases approximately 98,000 square feet of space, located in Redmond, Washington. The lease expires in 2008 with one option to renew to 2013. The Montreal, Quebec, Canada operations are in leased facilities of approximately 15,000 square feet. The lease expires in 2009. Upon expiration of its current leases, the Company believes that it will be able to secure renewal terms or enter into a lease for alternative locations.

 

 

There are no material pending legal proceedings, other than routine litigation incidental to the business, to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject.

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Not applicable

PART II

 

 

The table below sets forth the range of prices for the Company’s Common Stock, traded on the Nasdaq National Market System, for each quarterly period during the last two years. The approximate number of shareholders of record as of March 2, 2007, was 825 for Common Stock and 714 for Class B Stock.

 

 

 

The Company has not paid any cash dividends in the three-year period ended December 31, 2006. It has no plans to pay cash dividends as it plans to retain all cash from operations as a source of capital to finance growth in the business. There are no restrictions, however on the Company’s ability to pay dividends.

 

With respect to information regarding our securities authorized for issuance under equity incentive plans, the information contained in the section entitled “Equity Compensation Plan Information” of our definitive Proxy Statement for the 2007 Annual Meeting of Shareholders is incorporated herein by reference.

 

We did not repurchase any shares of our common stock in 2006.

 

The following graph charts the annual percentage change in return on the Company’s common stock compared to the S&P 500 Index — Total Return and the NASDAQ US and Foreign Securities:

 

Comparison of 5 Year Cumulative Total Return
Assumes Initial Investment of $100
December 2006

 

 

 

Five-Year Performance Highlights

 

 

 

 

 

OVERVIEW

 

Astronics Corporation, through its subsidiaries Astronics Advanced Electronic Systems Corp., Luminescent Systems Inc. and Luminescent Systems Canada Inc. designs and manufactures electrical power generation, control and distribution systems and lighting systems and components, for the aerospace industry. We operate four principal facilities located in New York State, New Hampshire, Washington State and Quebec, Canada. We serve the three primary aircraft markets which are the military, commercial transport and the business jet markets. In 2006, the break down of sales to the commercial transport market, the military market and the business jet market were 55%, 23% and 21%, respectively, miscellaneous sales to non aerospace markets accounted for 1% of sales. Astronics strives to offer comprehensive lighting and electrical systems for aircraft which we believe make the Company unique in our ability to serve our customers.

 

On February 3, 2005, the Company acquired substantially all of the assets of the General Dynamics — Airborne Electronic Systems (AES) business unit from a subsidiary of General Dynamics. Astronics acquired

the business for $13.0 million in cash. The Company financed the acquisition and related costs by borrowing $7.0 million on its revolving line of credit and used $6.4 million of cash on hand.

 

During the fourth quarter of 2006 we broke ground on a 57,000 square foot expansion to our East Aurora, New York facility. The budget for the building is approximately $4.6 million exclusive of manufacturing equipment which will be acquired as needed. We expect to permanently finance the project with a tax exempt bond offering expected to close during the first half of 2007. We anticipate the construction to be completed during the second quarter of 2007. The expansion will provide additional production capacity allowing for continued growth.

 

Key factors affecting Astronics’ growth are our ability to have our products designed into the plans for new aircraft, the rate at which new aircraft are produced, government funding of military programs, and the rates at which aircraft owners, including commercial airlines, refurbish or install upgrades to their aircraft. Once designed into a new aircraft, the spare parts business is frequently retained by the Company. Astronics’ strategy is to increase the amount of content on aircraft platforms, evolving the Company from our historic role of a components supplier to a turn key provider of complete systems.

 

One of the principal markets we serve is the commercial transport market. The 2005 acquisition of Astronics AES has increased our exposure to the commercial transport market. As the financial condition of the world’s airlines improves and stabilizes, the airlines are beginning to increase investments in new aircraft purchases and cabin improvements. Many airlines are expanding the number of seats equipped with in-flight entertainment systems and in-seat power. This in turn has resulted in a significant increase of sales for our cabin electronics product line. We believe we are in a strong position to continue to benefit from this trend. Our increased exposure to this market also means we have greater down side risk should the commercial transport market enter a period of retraction as it did for several years beginning in 2001. If that were to occur, it is likely that commercial airlines would reduce spending on these types of programs and have a significant negative impact on our business. The cabin electronics product line, which is principally sold to the commercial transport market, accounted for 41.3% of our sales in 2006 and 21.0% of our sales 2005.

 

The business jet market remained strong during 2006. We provide a wide range of products to the business jet market including cockpit lighting, exterior lighting and air frame power. Our products are found in aircraft manufactured by most of the leading business jet OEM’s such as Cessna, Raytheon and, Bombardier. An exciting development in the business jet market is the entry of the Very Light Jet (VLJ) into the market place. We believe the introduction of VLJ’s will provide an opportunity for Astronics to expand our core businesses. During 2006 two VLJ’s that feature Astronics products, the Eclipse 500 and the Cessna Mustang received FAA certification and are expected to enter production during 2007. There is a wide range of projected demand for this new class of aircraft. Our view is that the VLJ market will develop and our goal is to be positioned to take advantage of opportunities with each manufacturer. There is risk involved with any new aircraft should projected production be delayed or not achieved it would impact Astronics growth opportunities and expected profits. We believe that the business jet markets will continue to provide opportunities for growth provided the economy remains healthy.

 

Our Military market sales are typically comprised of several significant “programs” such as the power converter for the Tactical Tomahawk and Taurus missiles, complemented by many spare part orders covering many aircraft platforms. A large development effort over the past several years has been the exterior lighting suite for the F-35 Joint Strike Fighter. This aircraft is expected to enter low rate production in 2008 and we are in the process of negotiating a contract to support the low rate production phase of the program. The Military market is dependent on governmental funding which can change from year to year. Risks are that overall spending may be reduced in the future and that specific programs may be eliminated. Astronics does not have significant reliance on any one program such that cancellation of a particular program will cause material financial loss. We believe that we will continue to have opportunities similar to past years regarding this market.

 

We continue to look for opportunities to capitalize on our core competencies of power generation and distribution and lighting to expand our existing business and to grow through strategic acquisitions.

 

In 2006, Astronics continued to commit significant resources for the engineering and design of next generation products which in many cases did not enter production until late 2006 or have yet to enter production. Some of the more significant efforts during 2006 were products for the various OEM’s developing very light business jets such as Cessna Aircraft, Eclipse Aviation and Embraer. For the military markets our larger design and development efforts have been for the exterior lighting suite for the F-35 (Joint Strike Fighter) and several smaller programs. For the foreseeable future we expect that we will continue to have opportunities requiring levels of engineering resources comparable to 2006.

 

We are entering 2007 with strong momentum. Each of the markets that we serve is presenting opportunities that we expect will provide continued growth for the company. We are projecting 2007 revenues to be $140 million driven by a strong global and aerospace economy.

 

We ended the year with a backlog of $99.5 million of which approximately $85 million is expected to be delivered during 2007. Provided that the economy maintains its strength we anticipate that new aircraft build rates and aircraft operator spending will continue to increase over the next several years providing increased opportunities to grow revenue and profits. We expect discretionary spending by the airlines will continue as the global commercial transport market continues its recovery. We expect that the military market will continue to offer opportunities for us to increase the value of the content that we provide on a growing base of aircraft platforms.

 

Challenges facing us include improving shareholder value through profitability. Increasing profitability is dependent on many things such as increased build rates for existing aircraft, market acceptance and economic success of new aircraft such as the Cessna Mustang and Eclipse 500 business jets, continued government funding of defense programs such as the F-35 Joint Strike Fighter and V-22 Osprey and the Company’s ability to obtain production contracts for parts we currently supply or have been selected to design and develop for these programs. In addition we are faced with continued increasing health care and corporate governance costs, particularly those required by Sarbanes-Oxley legislation. Finally, many of our newer development programs are based on new and unproven technology. We are challenged to develop the technology on a schedule that is consistent with specific aircraft development programs. We will continue to address these challenges by working to improve operating efficiencies and focusing on executing on the growth opportunities currently in front of us.

 

CRITICAL ACCOUNTING POLICIES

 

Our financial statements and accompanying notes are prepared in accordance with U.S. generally accepted accounting principles. The preparation of the Company’s financial statements requires management to make estimates, assumptions and judgments that affect the amounts reported. These estimates, assumptions and judgments are affected by management’s application of accounting policies, which are discussed in Note 1 of Item 8, Financial Statements and Supplementary Data of this report. The critical accounting policies have been reviewed with the audit committee of our board of directors.

 

Revenue Recognition

 

Revenue is recognized on the accrual basis generally at the time of shipment of goods. There are no significant contracts allowing for right of return. The Company does evaluate and record an allowance for any potential returns based on experience and any known circumstances. For the years ended December 31, 2006 and 2005, no allowances were recorded for contracts allowing for right of return. A trade receivable is recorded at the value of the sale. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company records a valuation allowance to account for potentially uncollectible accounts receivable.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

The Company records a valuation allowance to account for potentially uncollectible accounts receivable. The allowance is determined based on Management’s knowledge of the business, specific customers, review of receivable agings and a specific identification of accounts where collection is at risk. At December 31, 2006,

the Company’s allowance for doubtful accounts for accounts receivable was $0.3 million, or 2% of gross accounts receivable. At December 31, 2005, the Company’s allowance for doubtful accounts for accounts receivable was $0.4 million, or 3% of gross accounts receivable. In addition, at December 31, 2006 and 2005, the Company fully reserved the balance of a non-current note receivable in the amount of $0.6 million.

 

Inventory Valuation

 

The Company records valuation reserves to provide for slow moving or obsolete inventory or to reduce inventory to the lower of cost or market value. In determining the appropriate reserve, Management considers the age of inventory on hand, the overall inventory levels in relation to forecasted demands as well as reserving for specifically identified inventory that the Company believes is no longer salable. At December 31, 2006, the Company’s reserve for inventory valuation was $4.1 million, or 11.6% of gross inventory. At December 31, 2005, the Company’s reserve for inventory valuation was $4.8 million, or 19.8% of gross inventory.

 

Deferred Tax Asset Valuation Allowances

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We record a valuation allowance to reduce deferred tax assets to the amount of future tax benefit that we believe is more likely than not to be realized. We consider recent earnings projections, allowable tax carryforward periods, tax planning strategies and historical earnings performance to determine the amount of the valuation allowance. Changes in these factors could cause us to adjust our valuation allowance, which would impact our income tax expense when we determine that these factors have changed.

 

As of December 31, 2006, the Company had a net deferred tax asset of $2.3 million, net of a $0.3 million valuation allowance, net of federal tax benefit. These assets relate principally to liabilities or asset valuation reserves that result in timing difference between generally acceptable accounting principles recognition and treatment for income tax purposes, as well as a state investment tax credit carry-forward.

 

Goodwill

 

The Company’s goodwill is the result of the excess of purchase price over net assets acquired from acquisitions. As of December 31, 2006, the Company had $2.7 million of goodwill. The Company tests goodwill for impairment at least annually, during the fourth quarter, and whenever events occur or circumstances change that indicates there may be impairment. The process of evaluating the Company’s goodwill for impairment is subjective and requires significant estimates. These estimates include judgments about future cash flows that are dependent on internal forecasts, long-term growth rates and estimates of the weighted average cost of capital used to discount projected cash flows. Based on the discounted projected cash flows, management has concluded that there is no impairment of the Company’s goodwill.

 

Supplemental Retirement Plan

 

The Company maintains a supplemental retirement plan for certain executives. The accounting for this plan is based in part on certain assumptions that may be highly uncertain and may have a material impact on the financial statements if different reasonable assumptions had been used. The assumptions for increases in compensation and the discount rate for determining the cost recognized in 2006 were 5.00% and 5.50% respectively. The discount rate used for the projected benefit obligation as of December 31, 2006 was 5.75%. The assumption for compensation increases takes a long-term view of inflation and performance based salary adjustments based on the Company’s approach to executive compensation. For determining the discount rate the Company considers long-term interest rates for high-grade corporate bonds.

RESULTS OF OPERATIONS

 

Sales

 

Sales for 2006 increased by $36.4 million to $110.8 million, up from $74.4 million in 2005, an increase of 48.9%. By market, the increase was primarily the result of an increase in sales to the commercial transport market of $31.0 million, an increase in sales to the business jet market of $7.5 million, partially offset by a $2.2 million decrease in sales to the military market.

 

The increase in sales to the Commercial transport market was primarily a result of $30.2 million increase from Cabin Electronics and a $1.3 million increase from the Cabin Lighting product line. The Cabin Electronics increase resulted from increased volume driven by increasing installations of in-seat power and in-flight entertainment systems. The increased sales from Cabin lighting was a result of increased volume. The increase of sales to the business jet market was primarily a result of $4.3 million increase from cockpit lighting, a $2.6 million increase in Airframe power sales and a $0.6 million increase of Exterior Lighting sales all driven by increasing production volumes of aircraft containing our products and increasing ship set content on those aircraft. The decrease of sales to the military was primarily related to a $4.8 million decrease in night vision retro fit kits program for the Korean Air Force was concluded in 2005 offset by increased sales to the Tactical Tomahawk and Taurus Missile programs of $2.5 million.

 

Sales for 2005 increased by $39.7 million to $74.4 million, up from $34.7 million in 2004, an increase of 114%. The increase was the result of the 2005 acquisition of AES, contributing $27.6 million and an increase in organic sales of $12.1 million. Organic sales increased in the business jet market by $4.0 million, the commercial transport market by $1.2 million and the military market by $7.0 million. These were offset partially by a $0.1 million decrease in sales to other markets. The increase in organic sales to the business jet market was primarily a result of increased production rates for new aircraft. The increase in organic sales to the military market was primarily the result of the Korean F-16 night vision retro-fit program which accounted for $4.8 million and an increase in overall volume on a wide variety of programs. Astronics AES 2005 sales were $0.7 million to the business jet market, $22.4 million to the commercial transport market and $4.5 million to the military market.

 

Expenses and Margins

 

Cost of products sold as a percentage of sales remained flat at 79.0% in 2006 from 80.0% in 2005. Leverage provided by the increased sales volume was offset somewhat by an increase in engineering and design costs. Engineering and design spending related primarily to product development increased by $2.0 million to $10.9 million in 2006 as compared with $8.9 million in 2005. It is our intention to continue investing in capabilities and technologies as needed that allows us to execute our strategy to increase the ship set content and value we provide on aircraft in all markets that we serve. The rate of spending on these activities, however, will largely be driven by opportunities that the market presents.

 

Cost of products sold as a percentage of sales decreased by 6.7 percentage points to 80.0% in 2005 from 86.7% in 2004. This decrease was due to improved margins for the organic business and the addition of Astronics AES that had 2005 cost of sales totaling 72.0% of sales. Cost of sales, for the organic business as a percentage of sales decreased two percentage points to 84.7% in 2005 from 86.7% in 2004. This was a result of leverage provided by the increased revenues somewhat offset by an increase for organic engineering and design costs of $1.4 million to $7.2 million in 2005 as compared with $5.8 million in 2004.

 

Selling, general and administrative expenses (“SG&A”) were $13.6 million in 2006, compared to $10.2 million in 2005. During 2006, the increase was primarily due to increased wages and benefits as well as increased costs for audit and other professional services related to Sarbanes-Oxley 404 implementation. As a percentage of SG&A expense was 12.3% compared to 13.8% for the same period of 2005 as sales grew at a faster pace than SG&A spending. Also, a portion of the 2006 year to date SG&A increase is due to the timing of the Astronics Advanced Electronic Systems acquisition. The acquisition date was February 3, 2005, as such 2005 contained only forty seven weeks of expenses for Astronics Advanced Electronic Systems as compared with fifty two weeks in 2006.

 

Selling, general and administrative expenses increased $4.7 million to $10.2 million in 2005 from $5.5 million in 2004 primarily as a result the incremental selling, general and administrative costs of $4.7 million from Astronics AES. Organic selling, general and administrative costs remained flat when compared to 2004. A $0.3 million decrease in bad debt expense offset a similar increase in professional services, principally related to increased accounting and audit costs.

 

Net interest expense was $0.9 million and $0.7 million in 2006 and 2005 respectively. Increased interest rates on our variable rate debt was the reason for the increase when compared to 2005. Net interest expense for 2005 was $0.7 million, an increase of $0.4 million from $0.3 million in 2004. The increase was due to increased debt levels and an increase in interest rates on our variable rate debt.

 

Income Taxes

 

The effective tax rate was 34.5% in 2006, 11.8 percentage points lower than the effective tax rate of 46.3% in 2005. The majority of the decrease was due to a reserve that we recorded to reduce our deferred tax assets relating to New York State investment tax credit carry forwards in the second quarter of 2005, a non-cash charge to income tax expense of $0.3 million, net of federal taxes combined with the impact of lower state income taxes. As we had anticipated for 2006 and expect for future years, the effective tax rate will continue to be closer to the statutory rates in effect.

 

The effective tax rate was 46.3% in 2005, 8.4 percentage points higher than the effective tax rate of 37.9% in 2004. The majority of the increase was due to a reserve that we recorded to reduce our deferred tax assets relating to New York State investment tax credit carry forwards. In 2005, new tax legislation was passed that we expect will reduce the allocation of future taxable income to New York State. As a result, we expect our future tax liability to be significantly reduced and do not expect to utilize all of these credits before they expire. In the second quarter of 2005, the Company recorded a valuation allowance reducing the Company’s $0.3 million deferred tax asset relating to these state tax credits to $0.03 million. As a result of this valuation allowance, the Company recorded a non-cash charge to income tax expense of $0.3 million, net of federal taxes.

 

Off Balance Sheet Arrangements

 

We do not have any material off balance sheet arrangements that have or are reasonably likely to have a material future effect on our results of operations or financial condition.

 

Contractual Obligations

 

 

 

 

Notes to Contractual Obligations Table

 

Note Payable and Long-Term Debt — See item 8, Financial Statements and Supplementary Data, Note 2, Long-Term Debt and Note Payable in this report.

 

Interest on Long-Term Debt — Interest on Long-Term Debt consists of payments on Industrial Revenue Bonds issued through the Erie County, New York Industrial Development Agency taking into account the interest rate swap entered into on February 6, 2006 which effectively fixes the interest rate on this obligation at 3.99% through January 2016. We have excluded the variable rate interest on our note payable and other long-term debt.

 

Operating Leases — Operating lease obligations are primarily related to facility and equipment leases for our Astronics AES operations and facility leases for our Canadian operations.

 

Purchase Obligations — These are comprised of the Company’s commitments for goods and services in the normal course of business.

 

Construction Obligations — These are comprised of the Company’s commitments for construction of 57,000 square feet of manufacturing capacity in East Aurora, New York.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash flow used by operating activities was $0.05 million in 2006 compared with $5.0 million provided by operating activities in 2005. The decrease of $5.05 million as compared with 2005 was mainly a result of an increase in income from continuing operations of $3.5 million to $5.7 million in 2006 from net income in 2005 of $2.2 million, adjustments for non-cash charges such as depreciation and amortization of $2.9 million, being offset by a net decrease in investment in working capital components, primarily receivables, inventory and payables. The increase in investment in working capital components during 2006 was driven by the Company’s sales growth. Cash flow provided by operating activities was $5.0 million in 2005 compared with $0.1 million in 2004. The increase in 2005 relates to higher income from continuing operations adjusted for non-cash charges such as depreciation and amortization of $2.4 million, offset somewhat by slight increase in working capital components.

 

The Company’s cash flows from operations are primarily dependent on its sales, profit margins and the timing of collections of receivables, volume of inventory and payments to suppliers. Sales are influenced significantly by the build rates of new aircraft, which amongst other things are subject to general economic conditions, government appropriations and airline passenger travel. Over time, sales will also be impacted by the Company’s success in executing its strategy to increase ship set content and obtain production orders for programs currently in the development stage. A significant change in new aircraft build rates could be expected to impact the Company’s profits and cash flow. A significant change in government procurement and funding and the overall health of the worldwide airline industry could be expected to impact the Company’s profits and cash flow as well.

 

Cash used for investing activities was $5.5 million in 2006 compared with $15.0 million in 2005, a $9.5 million decrease. This decrease was primarily due to a combination of the prior year including the Astronics AES acquisition of $13.4 million with no comparable acquisition in 2006 offset by increased in capital expenditures of approximately $2.9 million in 2006. Cash used for investing activities in 2004 was $2.4 million, primarily due to capital purchases of $1.1 million and net increases in short-term investment of $1.0 million.

 

The Company’s cash required for capital equipment purchases for the last three years ranged between $1.1 million and $5.4 million. Our expectation for 2007 is that capital equipment expenditures will approximate $13 million. This expected increase is primarily a result of completion of the East Aurora building expansion and machinery and equipment purchases to increase our production capacity. The building expansion as well as the new facility’s machinery and equipment will likely be financed with additional long-term debt. Future capital requirements depend on numerous factors, including expansion of existing product

lines and introduction of new product lines. Management believes that the Company’s cash flow from operations and current borrowing arrangements will provide for these necessary capital expenditures.

 

In January, 2007 the Company entered into a new agreement with HSBC Bank USA which increases its available revolving credit facility to $20 million. The agreement is a two year facility. We believe that should our facility with HSBC not be renewed we will be able to obtain alternative senior debt financing arrangements. At December 31, 2006, the Company was in compliance with all of the covenants pursuant to the credit facility in existence with HSBC Bank USA at that time.

 

The Company’s cash needs for debt service for 2007 are expected to increase from 2006 levels. The Company is planning on financing its building expansion with Industrial Revenue Bonds. The impact of the credit facility balance and the Industrial Revenue Bonds on cash needs in 2007 will depend on the repayment terms in those agreements.

 

The Company’s ability to maintain sufficient liquidity is highly dependent upon achieving expected operating results. The Company has successfully negotiated new credit terms with its lender in order to provide more operating flexibility than it previously had. However, failure to achieve expected operating results could have a material adverse effect on our liquidity and our operations in the future.

 

The Company’s cash needs for working capital, capital equipment and debt service during 2007 and the foreseeable future, are expected to be met by cash flows from operations and if necessary, utilization of its revolving credit facility.

 

DIVIDENDS

 

Management believes that it should retain the capital generated from operating activities for investment in advancing technologies, acquisitions and debt retirement. Accordingly, there are no plans to institute a cash dividend program.

 

BACKLOG

 

At December 31, 2006, the Company’s backlog was $99.5 million compared with $96.1 million at December 31, 2005.

 

RELATED-PARTY TRANSACTIONS

 

See the discussion in Item 8, Financial Statements and Supplementary Data, Note 11, Discontinued Operations in this report.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In June 2006, the FASB issued Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes — an Interpretation for SFAS No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” The pronouncement prescribes a recognition threshold and measurement attributable to financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of determining the effect, if any; the adoption of FIN 48 will have on our consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. This statement establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurement. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is in the process of determining the effect, if any; the adoption of SFAS No. 157 will have on our consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R).” The Statement requires employers to fully recognize the obligations associated with single-employer defined benefit pension, retiree healthcare and other postretirement plans in their financial statements with changes in funded status being recognized in comprehensive income in the year in which the changes occur. This requirement is effective for fiscal years ending after December 15, 2006. Statement 158 also requires companies to measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions) instead of permitting companies to use a lag of up to three-months permitted by SFAS No. 87, “Employers’ Accounting for Pensions”, and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”. This requirement is effective for fiscal years ending after December 15, 2008. The Company has adopted the provisions of SFAS No. 158 as of December 31, 2006, the effect of which was to increase retirement liabilities by $2.3 million, deferred taxes by $0.9 million and other comprehensive income by $1.4 million. There was no impact to net income for the year ended December 31, 2006.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which allows measurement of specified financial instruments, warranty and insurance contracts at fair value on a contract by contract basis, with changes in fair value recognized in earnings in each period. SFAS 159 is effective at the beginning of the fiscal year that begins after November 15, 2007, and will be effective for the Company in fiscal 2008. The Company has not yet determined the effect that the implementation of this standard will have on its consolidated financial position or results of operations.

 

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 on Quantifying Financial Statement Misstatements (SAB 108). SAB 108 sets forth the SEC staff’s views that registrants should quantify errors using both a balance sheet and an income statement approach, and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective the first fiscal year ending after November 15, 2006. The Company’s adoption of SAB 108 did not have a material impact on its results of operations, financial position, or cash flows.

 

 

The Company has limited exposure to fluctuation in Canadian currency exchange rates to the U.S. dollar. Nearly all of the Company’s consolidated sales, expenses and cash flows are transacted in U.S. dollars. Net assets held in or measured in Canadian dollars amounted to $0.03 million at December 31, 2006. Annual disbursements of approximately $6.1 million are transacted in Canadian dollars. A 10% change in the value of the U.S. dollar versus the Canadian dollar would impact net income by approximately $0.4 million.

 

Risk due to fluctuation in interest rates is a function of the Company’s floating rate debt obligations, which total approximately $18.4 million at December 31, 2006. To offset this exposure, the Company entered into an interest rate swap in February 2006, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this $4.0 million obligation through January 2016. As a result, a change of 1% in interest rates would impact annual net income by less than $0.1 million.

 

REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders and Board of Directors of Astronics Corporation

 

We have audited the accompanying consolidated balance sheet of Astronics Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Astronics Corporation at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note 1 to the consolidated financial statements, on January 1, 2006 the Company changed its method of accounting for stock-based compensation and on December 31, 2006 the Company changed its method of accounting for defined benefit pension and other postretirement benefits.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Astronics Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2007 expressed an unqualified opinion on management’s assessment and an adverse opinion on the effectiveness of internal control over financial reporting.

 

 

Buffalo, New York

March 14, 2007

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. The Company’s management has assessed the effectiveness of its internal control over financial reporting as of December 31, 2006. This evaluation was based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management identified a material weakness in connection with its design and implementation of adequate controls over the selection and application of accounting policies for revenue recognition on bill and hold contracts. The Company determined that the transactions did not meet certain of the discrete criteria required by the Securities and Exchange Commission in Staff Accounting Bulletin (SAB) No. 104 to recognize revenue prior to shipment under bill-and-hold arrangements. As a result, the Company has restated its previously issued consolidated financial statements for the year ended December 31, 2005.

 

Solely, as a result of the material weakness identified, Senior Management has concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2006, based on the criteria described in the COSO Internal Control — Integrated Framework.

 

Ernst & Young LLP, independent registered public accounting firm, has audited our consolidated financial statements included in this Annual Report on Form 10-K and, as part of their audit, has issued their report, included herein, (1) on our management assessment of the effectiveness of our internal control over financial reporting and (2) on the effectiveness of our internal control over financial reporting.

 

Peter J. Gundermann

President & Chief Executive Officer

(Principal Executive Officer)

 

David C. Burney

Vice President-Finance, Chief Financial Officer & Treasurer

(Principal Financial and Accounting Officer)

REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

 

The Shareholders and Board of Directors of Astronics Corporation

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Astronics Corporation did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of the material weakness identified in management’s assessment, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Astronics Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management identified a material weakness in connection with its design and implementation of adequate controls over the selection and application of accounting policies for revenue recognition on bill and hold contracts. The Company determined that the transactions did not meet certain of the discrete criteria required by the Securities and Exchange Commission in Staff Accounting Bulletin (SAB) No. 104 to recognize revenue prior to shipment under bill-and-hold arrangements. As a result, the Company has restated its previously-issued consolidated financial statements for the year ended December 31, 2005. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 financial statements, and this report does not affect our report dated March 14, 2007 on those financial statements.

 

In our opinion, management’s assessment that Astronics Corporation did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Astronics Corporation has not maintained effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

 

 

Buffalo, New York

March 14, 2007

ASTRONICS CORPORATION

 

CONSOLIDATED STATEMENT OF OPERATIONS

 

 

See notes to consolidated financial statements.

ASTRONICS CORPORATION

 

CONSOLIDATED BALANCE SHEET

 

 

See notes to consolidated financial statements.

ASTRONICS CORPORATION

 

CONSOLIDATED STATEMENT OF CASH FLOWS

 

 

See notes to consolidated financial statements.

 

ASTRONICS CORPORATION

 

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

 

 

See notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES AND PRACTICES

 

Description of the Business

 

Astronics Corporation, through its subsidiaries Luminescent Systems, Inc., Luminescent Systems-Canada Inc. and Astronics Advanced Electronic Systems Corp. (AES) designs and manufactures lighting components and subsystems, electrical power generation, in-flight control and power distribution systems for aircraft. The Company serves the three primary markets for aircraft which are the military, commercial transport and the business jet markets.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated.

 

Acquisitions are accounted for under the purchase method and, accordingly, the operating results for the acquired companies are included in the consolidated statements of earnings from the respective dates of acquisition.

 

Revenue and Expense Recognition

 

Revenue is recognized on the accrual basis generally at the time of shipment of goods. There are no significant contracts allowing for right of return. The Company does evaluate and record an allowance for any potential returns based on experience and any known circumstances. For the years ended December 31, 2006 and 2005, no allowances were recorded for contracts allowing for right of return. A trade receivable is recorded at the value of the sale. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company records a valuation allowance to account for potentially uncollectible accounts receivable. The allowance is determined based on Management’s knowledge of the business, specific customers, review of receivable agings and a specific identification of accounts where collection is at risk. At December 31, 2006, the Company’s allowance for doubtful accounts for accounts receivable was $0.3 million, or 1.8% of gross accounts receivable. At December 31, 2005, the Company’s allowance for doubtful accounts for accounts receivable was $0.4 million, or 3.0% of gross accounts receivable. In addition, at December 31, 2006 and 2005, the Company fully reserved the balance of a non-current note receivable in the amount of $0.6 million.

 

Cost of products sold includes the costs to manufacture products such as direct materials and labor and manufacturing overhead as well as all engineering and developmental costs. Shipping and handling costs are expensed as incurred and are included in costs of products sold. Selling, general and administrative expenses include costs primarily related to our sales and marketing departments and administrative departments.

 

The Company is engaged in a variety of engineering and design activities as well as basic research and development activities directed to the substantial improvement or new application of the Company’s existing technologies. These costs are expensed when incurred and included in cost of sales. Research and development and related engineering amounted to $10.9 million in 2006, $8.9 million in 2005 and $5.8 million in 2004.

 

Stock-Based Compensation

 

During the first quarter of 2006, the Company adopted SFAS 123(R), “Share-Based Payment,” applying the modified prospective method. This Statement requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the statement of earnings based on the grant date fair value of the award. Under the modified prospective method, the Company is required to record equity-based compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards outstanding as of the date of adoption. The Company’s prior years will not reflect any restated amounts. For awards with graded vesting, the Company uses a straight-line method of attributing the value of stock-based compensation expense, subject to minimum levels of expense, based on vesting. Prior

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to the first quarter of 2006 the Company accounted for its stock-based awards using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 and its related interpretations. The measurement prescribed by APB Opinion No. 25 does not recognize compensation expense if the exercise price of the stock option equals the market price of the underlying stock on the date of grant and the number of stock options granted is fixed. Accordingly, no compensation expense related to stock options has been recorded in the financial statements prior to the first quarter of 2006.

 

Under SFAS 123(R), stock compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Vesting requirements vary for directors, officers and key employees. In general, options granted to outside directors vest six months from the date of grant and options granted to officers and key employees vest with graded vesting over a five-year period, 20% each year, from the date of grant.

 

The following table provides pro forma earnings information as if the Company recorded compensation expense based on the fair value of stock options for the years ended December 31, 2006, 2005 and 2004:

 

 

 

 

Consistent with SFAS 123(R), we classified $0.1 million of excess tax benefits from share based payment arrangements as cash flows from financing activities.

 

Cash and Cash Equivalents

 

All highly liquid instruments with a maturity of three months or less at the time of purchase are considered cash equivalents.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Inventories

 

Inventories are stated at the lower of cost or market, cost being determined in accordance with the first-in, first-out method. Inventories at December 31 are as follows:

 

 

The Company records valuation reserves to provide for slow moving or obsolete inventory or to reduce inventory to the lower of cost or market value. In determining the appropriate reserve, Management considers the age of inventory on hand, the overall inventory levels in relation to forecasted demands as well as reserving for specifically identified inventory that the company believes is no longer salable. At December 31, 2006, the Company’s reserve for inventory valuation was $4.1 million, or 11.6% of gross inventory. At December 31, 2005, the Company’s reserve for inventory valuation was $4.8 million, or 19.8% of gross inventory. This is a decrease of $0.7 million, which represented 1.8% of the December 31, 2006 gross inventories.

 

Property, Plant and Equipment

 

Depreciation of property, plant and equipment is computed on the straight-line method for financial reporting purposes and on accelerated methods for income tax purposes. Estimated useful lives of the assets are as follows: buildings, 40 years; machinery and equipment, 4-10 years. Leasehold improvements are amortized over the terms of the lease or the lives of the assets, whichever is shorter.

 

The cost of properties sold or otherwise disposed of and the accumulated depreciation thereon are eliminated from the accounts, and the resulting gain or loss, as well as maintenance and repair expenses, are reflected in income. Replacements and improvements are capitalized.

 

Depreciation expense was $2.4 million, $1.9 million and $1.0 million in 2006, 2005 and 2004, respectively.

 

Goodwill and Intangible Assets

 

The Company tests goodwill at the reporting unit level on an annual basis or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company has one reporting unit for purposes of the goodwill impairment test. The impairment test consists of comparing the fair value of the reporting unit, determined using discounted cash flows, with its carrying amount including goodwill, and, if the carrying amount of the reporting unit exceeds its fair value, comparing the implied fair value of goodwill with its carrying amount. An impairment loss would be recognized for the carrying amount of goodwill in excess of its implied fair value.

 

Intangibles are valued based upon future economic benefits such as discounted earnings and cash flows. Acquired identifiable intangible assets are recorded at cost and are amortized over their estimated useful lives. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of those assets may not be recoverable. Trade name intangibles have an indefinite life and are tested for impairment on an annual basis or more frequently if an event occurs or circumstances change that would more likely than not reduce its fair value below its carrying amount.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Long-Lived Assets

 

Long-lived assets to be held and used are initially recorded at cost. The carrying value of these assets is evaluated for recoverability whenever adverse effects or changes in circumstances indicate that the carrying amount may not be recoverable. Impairments are recognized if future undiscounted cash flows and earnings from operations are not expected to be sufficient to recover long-lived assets. The carrying amounts are then reduced by the estimated shortfall of the discounted cash flows.

 

Financial Instruments

 

The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivable, accounts payable, notes payable, long-term debt and an interest rate swap. The carrying value of the Company’s financial instruments approximate fair value. The Company does not hold or issue financial instruments for trading purposes.

 

Derivatives

 

The Company records all derivatives on the balance sheet at fair value and as long term. The accounting for changes in the fair value of derivatives depends on the intended use and resulting designation. During 2006 and 2005, the Company’s use of derivative instruments was limited to a cash flow hedge of interest rate risk. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (“OCI”) and subsequently reclassified into earnings when the hedged exposure affects earnings. The Company entered into an interest rate swap in February 2006, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this obligation through January 2016. This arrangement replaced a swap agreement that expired in December 2005 which effectively fixed the interest rate at 4.09%. The ineffective portions of all derivatives are recognized immediately into earnings as other income or expense. Ineffectiveness was not material in 2006, 2005, and 2004. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. The Company classifies the cash flows from hedging transactions in the same category as the cash flows from the respective hedged items. The Company reclassified $0.02 million; $0.1 million and $0.2 million from accumulated other comprehensive income to interest expense during 2006, 2005 and 2004, respectively.

 

Income Taxes

 

The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities. Deferred tax assets are reduced, if deemed necessary, by a valuation allowance for the amount of tax benefits which are not expected to be realized. Investment tax credits are recognized on the flow through method.

 

Earnings per Share

 

Earnings per share computations are based upon the following table:

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The effect of stock options has not been included for 2004 since this would be anti-dilutive as a result of the Company’s net loss.

 

Class B Stock

 

Class B Stock is identical to Common Stock, except Class B Stock has ten votes per share, is automatically converted to Common Stock on a one for one basis when sold or transferred, and cannot receive dividends unless an equal or greater amount is declared on Common Stock. At December 31, 2006, approximately 3.0 million shares of common stock were reserved for issuance upon conversion of the Class B stock, exercise of stock options and purchases under the Employee Stock Purchase Plan.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities and the reported amounts of revenues and expenses during the reporting periods in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

Comprehensive Income

 

Comprehensive income (loss) consists primarily of net earnings and the after-tax impact of currency translation adjustments, mark to market adjustment for derivatives and retirement liability adjustments. Income taxes related to derivatives and retirement liability adjustments within other comprehensive income are generally recorded based on an effective tax rate of approximately 36%. No income tax effect is recorded for currency translation adjustments.

 

The accumulated balances of the components of other comprehensive (loss) income net of tax, at December 31, 2006 and 2005 are as follows:

 

 

Recent Accounting Pronouncements

 

In June 2006, the FASB issued Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes — an Interpretation for SFAS No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with for Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” The pronouncement prescribes a recognition threshold and measurement attributable to financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of determining the effect, if any; the adoption of FIN 48 will have on our consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. This statement establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurement. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is in the process of determining the effect, if any; the adoption of SFAS No. 157 will have on our consolidated financial statements.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 on Quantifying Financial Statement Misstatements (SAB 108). SAB 108 sets forth the SEC staff’s views that registrants should quantify errors using both a balance sheet and an income statement approach, and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective the first fiscal year ending after November 15, 2006. The Company’s adoption of SAB 108 did not have a material impact on its results of operations, financial position, or cash flows.

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No 87, 88, 106, and 132(R). SFAS No. 158 requires plan sponsors of defined benefit pension and other postretirement benefit plans (collectively, “postretirement benefit plans”) to recognize the funded status of their postretirement benefit plans in the statement of financial position, measure the fair value of plan assets and benefit obligations as of the date of the fiscal year-end statement of financial position, and provide additional disclosures. On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158. The effect of adopting SFAS No. 158 on the Company’s financial condition at December 31, 2006 has been included in the accompanying consolidated financial statements. SFAS No. 158 did not have an effect on the Company’s consolidated financial condition at December 31, 2005 or 2004. SFAS No. 158’s provisions regarding the change in the measurement date of postretirement benefit plans are not applicable as the Company already uses a measurement date of December 31 for its benefit plans. The Company has adopted the provisions of SFAS No. 158 as of December 31, 2006. See Note 6 for further discussion of the effect of adopting SFAS No. 158 on the Company’s consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which allows measurement of specified financial instruments, warranty and insurance contracts at fair value on a contract by contract basis, with changes in fair value recognized in earnings in each period. SFAS 159 is effective at the beginning of the fiscal year that begins after November 15, 2007, and will be effective for the Company in fiscal 2008. The Company has not yet determined the effect that the implementation of this standard will have on its consolidated financial position or results of operations.

 

Reclassifications

 

Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

NOTE 2 — LONG-TERM DEBT AND NOTE PAYABLE

 

Long-term debt consists of the following:

 

 

Principal maturities of long-term debt for each of the next five years are $0.9 million.

 

Interest capitalized in the 4^th quarter relating to the building expansion in New York was insignificant. No interest costs were capitalized in 2005 and 2004.

 

The Company is in compliance with all its debt and credit facility covenants at December 31, 2006 and believes it will continue to be compliant in the future.

 

The Industrial Revenue Bonds are held by institutional investors and are guaranteed by a bank letter of credit, which is collateralized by certain property, plant and equipment assets, the carrying value of which approximates the principal balance on the bonds.

 

The Company has a standby unsecured bank letter of credit guaranteeing the note payable in Canada, the carrying value of which approximates the principal balance on the note.

 

To offset risks due to fluctuation in interest rates, the Company entered into an interest rate swap on the New York Industrial Revenue Bond through December 2005 which effectively fixed the interest rate at 4.09%. In February 2006, the Company entered into a new interest rate swap, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this $4.3 million obligation through January 2016.

 

At December 31, 2006 and 2005 the Company had outstanding $8.1 million and $7.0 million respectively, on its revolving $15 million credit facility; with interest at bank prime or LIBOR plus 125 basis points. At December 31, 2006 and 2005, the Company had available $6.9 million and $8.0 million, respectively, on the facility.

 

On January 5, 2007 the Company restructured its bowering agreement with HSBC Bank USA, increasing the revolving credit facility to $20 million with interest at bank prime minus between 0 and 25 basis points or LIBOR plus between 87.5 and 175 basis points. The Company is also required to pay a commitment fee of between 0.125% and 0.30% on the unused portion of the line limit borrowing availability for the previous quarter. The Company may allocate up to $0.5 million of its availability for the issuance of new letters of credit. This new credit facility is collateralized by accounts receivable and inventory. The Company believes it will be compliant in the future with all the new credit facility covenants.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

NOTE 3 — STOCK OPTION AND PURCHASE PLANS

 

The Company has stock option plans that authorize the issuance of options for shares of Common Stock to directors, officers and key employees. Stock option grants are designed to reward long-term contributions to the Company and provide incentives for recipients to remain with the Company. The exercise price, determined by a committee of the Board of Directors, may not be less than the fair market value of the Common Stock on the grant date. Options become exercisable over periods not exceeding ten years. The Company’s practice has been to issue new shares upon the exercise of the options.

 

During the first quarter of 2006, the Company adopted SFAS 123(R), “Share-Based Payment,” applying the modified prospective method. This Statement requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the statement of earnings based on the grant date fair value of the award. Under the modified prospective method, the Company is required to record equity-based compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards outstanding as of the date of adoption. The Company uses a straight-line method of attributing the value of stock-based compensation expense, subject to minimum levels of expense, based on vesting schedules.

 

Stock compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Vesting requirements vary for directors, officers and key employees. In general, options granted to outside directors vest six months from the date of grant and options granted to officers and key employees straight line vest over a five-year period from the date of grant.

 

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The weighted average fair value of the options was $7.58, $3.97 and $2.30 for options granted during the year ended December 31, 2006, 2005 and 2004 respectively.

 

The fair value for these options was estimated at the date of grant using a Black- Scholes option pricing model with the following weighted-average assumptions:

 

 

To determine expected volatility, the Company uses historical volatility based on weekly closing prices of its Common Stock and considers currently available information to determine if future volatility is expected to differ over the expected terms of the options granted. The risk-free rate is based on the United States Treasury yield curve at the time of grant for the appropriate term of the options granted. Expected dividends are based on the Company’s history and expectation of dividend payouts. The expected term of stock options is based on vesting schedules, expected exercise patterns and contractual terms.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

A summary of the Company’s stock option activity and related information for the years ended December 31 follows:

 

 

The aggregate intrinsic value in the preceding table represents the total pretax option holder’s intrinsic value, based on the Company’s closing stock price of Common Stock which would have been received by the option holders had all option holders exercised their options as of that date. The Company’s closing stock price of Common Stock was $17.13, $10.75 and $5.10 as of December 31, 2006, 2005 and 2004, respectively.

 

The fair value of options vested during 2006, 2005 and 2004 was $3.95, $3.24 and $3.59, respectively. At December 31, 2006, total compensation costs related to non-vested awards not yet recognized amounts to $1.1 million and will be recognized over a weighted average period of 2.5 years.

 

The following is a summary of weighted average exercise prices and contractual lives for outstanding and exercisable stock options as of December 31, 2006: